Chapter 2

The Market
System and the
Circular Flow

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 Economic Systems

Economic systems
Set of institutionalized arrangements
Coordinating mechanism
Differences in systems exist by
Degree of decentralized use of
markets and prices in decision-making
Degree of centralized government
control

LO 2-2
 Laissez-Faire Capitalism

Ideal economy
Keep the government from interfering
with the economy
Power of government just needed to
Protect private property from theft
Provide a legal environment for
contract enforcement
People interact in markets to buy and sell

LO 2-3
 The Command System

The command system is known as

socialism or communism
Government ownership of resources
Decisions made by a central planning
board
North Korea, Cuba, Myanmar

LO 2-4
 The Market System

The market system is a mix of

decentralized decision making with
some government control
Systems found in much of the world
Private markets are dominant force
Private ownership of resources
Self-interested behavior

LO 2-5
 Characteristics of the Market
System

Private property
Freedom of enterprise
Freedom of choice
Self-interest
Competition
Market and prices

LO 2-6
 Global Perspective

LO 2-7
 Technology and Capital Goods

Advanced technology and capital

goods are encouraged
Specialization
Division of labor
Geographic specialization

LO 2-8
 Use of Money

Money makes trade easier

Medium of exchange
Without money, people would have to barter

LO 2-9
 Active, but Limited
Government
Government may be needed to
alleviate market failures
Government can increase
effectiveness of a market system
Possible government failure

LO 2-10
 The Five Fundamental
Questions
What goods and services will be
produced?
How will the goods and services be
produced?
Who will get the goods and services?
How will the system accommodate
change?
How will the system promote progress?

LO 2-11
 What Will Be Produced?

Goods and services that create a profit

Consumer sovereignty
Dollar votes
Method for consumers to determine
which goods will be produced
Determines which products and
industries survive or fail

LO 2-12
 How Will the Goods Be
Produced?
Minimize the cost per unit by using
the most efficient techniques
Technology
Prices of the necessary resources

LO 2-13
 How Will the Goods Be
Produced?
Three Techniques for Producing $15 Worth of Bar Soap
Units of Resource
Technique Technique 2 Technique 3
Price per 1
unit of
Resource
Resource Uni Cost Units Cost Units Cost
ts
Labor $2 4 $ 8 2 $ 4 1 $ 2
Land $1 1 1 3 3 4 4
Capital $3 1 3 1 3 2 6
Entrepreneu $3 1 3 1 3 1 3
r
$ 15 $ 13 $ 15

LO 2-14
 Who Will Get the Output?

Consumers with the ability and

willingness to pay will get the
product
Ability to pay depends on income

LO 2-15
 How Will the System Change?

Changes in consumer tastes

Changes in technology
Changes in resource prices

LO 2-16
 How Will the System Progress?

Technological advance
Creative destruction
Capital accumulation

LO 2-17
 The Invisible Hand

The invisible hand

1776 Wealth of Nations by Adam
Smith
Unity of private and social interest
Virtues of the market system
Efficiency
Incentives
Freedom
LO 2-18
 The Demise of Command
Systems
Command system was a failure
Soviet Union, Eastern Europe, and
China
The coordination problem
Set output targets for all goods
The incentive problem
No adjustments for surplus or
shortage
LO 2-19
 The Circular Flow Model

The circular flow diagram

Households
Businesses
Sole proprietorship
Partnership
Corporation
Product market and the resource
market
The real flow and the money flow

LO 2-20
 The Circular Flow Model

RESOURCE
MARKET
Households
sell
Businesses buy

BUSINESSES HOUSEHOLDS
buy sell
resources resources
sell products buy products

PRODUCT
MARKET
Businesses sell
Households
buy
LO 2-21
 How the System Deals with
Risk
Business owners and investors face risk
Losses due to input shortages
Changes in consumer tastes
Natural disasters that affect the
supply chain
Employees and suppliers have security
Paid whether the firm makes a profit
or not

LO 2-22
 How the System Deals with
Risk
Business risks are restricted to owners
Attracts needed inputs
Inputs easier to obtain since many dislike
risk
Focuses attention
Owners personally responsible for
outcome
Will encourage prudent decisions
Manage risk well and the owners will prosper

LO 2-23
 Shuffling the Deck

Extremely large number of ways to

arrange a deck of cards
Arrangement of economys resources
is even larger
Avoid random outcomes in market
due to
Private property
Rational decisions about property
2-24